The Unintended Consequences of PCAOB Auditing Standards ...

The Unintended Consequences of PCAOB Auditing Standards Nos. 2 and 3 on the Reliability of Preliminary Earnings Releases

Scott N. Bronson Michigan State University

bronson@bus.msu.edu

Chris E. Hogan Michigan State University

hogan@bus.msu.edu

Marilyn F. Johnson Michigan State University john1614@bus.msu.edu

K. Ramesh Rice University rameshk@rice.edu

We thank S.P. Kothari (the editor), Bill Kinney (the reviewer), Joe Carcello, Mark Evans, Karla Johnstone, Brian Mayhew, Terry Warfield, Hal White, Jeff Wooldridge, participants at the 2007 ANCAAR Audit Research Forum at The Australian National University, seminar participants at Texas A&M University, the University of Wisconsin, the University of Tennessee and the University of Illinois, and participants at the Michigan State University Brownbag Series, and participants at the 2008 International Symposium on Audit Research for their helpful comments on earlier versions of the paper. We thank several audit practitioners for their input on various institutional issues. We also thank Edward Li, Kay Li, Dara Marshall, Jamey Messer, and Joe Schroeder for research assistance. Part of the research was completed when K. Ramesh was an academic fellow at the Securities and Exchange Commission, which, as a matter of policy, disclaims responsibility for any private publication or statements by any of its employees or contractors. The views expressed herein are those of the authors and do not necessarily reflect those of the Commission or its staff.

The Unintended Consequences of PCAOB Auditing Standards Nos. 2 and 3 on the Reliability of Preliminary Earnings Releases

Abstract Implementation of Public Company Accounting Oversight Board Auditing Standards No. 2 on internal control and No. 3 on documentation has delayed audit completion. In response, most firms maintain the same preliminary earnings release date due to market demand for timely disclosures even though the audit may not be complete as of that date. Results indicate revisions to preliminary announcements when filing the 10-K report would have been 35% lower during 2005 if the historical frequency of issuing earnings releases after the audit report date had not changed. Additionally, stock market reactions to impending revisions suggests lower reliability of preliminary earnings.

Keywords: audit report lag, audit report date, audit regulation, earnings announcement date, preliminary earnings reliability, unintended consequences

The Unintended Consequences of PCAOB Auditing Standards Nos. 2 and 3 on the Reliability of Preliminary Earnings Releases

1. Introduction This study examines how the internal control audit requirements as implemented

by the Public Company Accounting Oversight Board in Auditing Standard No. 2 ("AS2"; PCAOB 2004b) and the audit documentation requirements of PCAOB Auditing Standard No. 3 ("AS3"; PCAOB, 2004a) impacted the reliability of information provided in earnings announcements. While both PCAOB AS2 and AS3 were expected to enhance the quality of the external audit, they also increased the amount of time required to complete the audit. Consequently, many firms that routinely released preliminary earnings numbers after completion of audit fieldwork must now trade off the market demand for timely information against a possible reduction in reliability due to issuing preliminary earnings numbers prior to the audit report date.1

Using a large sample of annual earnings releases over the period 2000-2005, we document a discontinuity in the average length of time between the fiscal year-end and the audit report date ("audit report lag") that is concurrent with the implementation of PCAOB AS2 and AS3. Audit report lags in the 2000-2003 period, which preceded these regulatory changes, average 46 - 50 days. In contrast, following the regulatory changes, 2004 and 2005 audit report lags increased to 62 and 65 days, respectively. The incidence of firms announcing earnings after the audit report date declined from close to 70% in the

1 The following quote from a 2002 comment letter by a Big-4 firm to the SEC provides the auditors' perspective on the reliability of information in earnings releases: "The status of the auditor's work as of the date of the earnings release necessarily varies from company to company. In some cases, significant work remains to be performed and little, if any, assurance can be ascribed to the publicly disclosed results. More often, the external auditor may have performed the majority of the audit or review procedures, or even substantially completed the audit fieldwork" ().

2000-2001 period to around 20% in 2005. We further document that this change is predominantly due to accelerated filers that had to comply with both AS2 and AS3, although there are still significant changes for the non-accelerated filers that had to comply with only AS3.

Noting that the release of preliminary earnings prior to the audit report date implies a relevance-reliability trade-off, we examine the factors that influenced this tradeoff in the pre-regulation period. In the pre-AS2/AS3 period we find that the choice to report preliminary earnings prior to the audit report date is positively associated with the demand by investors for timely disclosure and with accounting/audit complexity. Results are mixed on variables capturing proprietary costs and legal liability. We also find that firms with a December fiscal year-end (a proxy for the audit busy season) were less likely to wait for audit completion, reflecting overall supply constraints in the audit marketplace. Consistent with regulatory oversight providing an assurance of reporting reliability, utilities and financial institutions were more likely to release earnings prior to the audit report date (see also Altamuro and Beatty, 2008). Overall, our evidence is indicative of managers trading off relevance for potentially lower reliability.

To the extent the new regulations increase the proportion of firms announcing earnings prior to the audit report date, we expect a commensurate decrease in the reliability of preliminary earnings information in the marketplace. To test this prediction, we examine PEA revisions, which we define as cases in which income before extraordinary items (IBEI) as reported in the preliminary annual earnings announcement (PEA) differs from the number subsequently reported in the audited 10-K filing. We document that the preliminary number is released after the audit report date in only 38 of

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the 544 PEA revisions over the 2000-2005 period, suggesting that the external audit enhances the reliability of financial statements. Consistent with the increase in the proportion of firms whose preliminary releases contain pre-audit report date numbers, we show that the number of PEA revisions in our sample has increased over time from 12 in 2000 to 186 in 2005. After controlling for characteristics of firms with PEA revisions (Hollie et al., 2006), we find that PEA revisions are significantly more likely when preliminary earnings are released prior to the audit report date. Our inferences generally hold during the entire sample period (i.e., both before and after the effective dates of PCAOB AS2 and AS3) for both accelerated and non-accelerated filers and after we control for the number of days by which the earnings announcement precedes the audit report date (a proxy for the likelihood of subsequent events). Taken together, the unintended regulatory effect we document is economically significant in that PEA revisions would have been 35% lower during 2005 if the historical frequency of issuing earnings releases after the audit report date had not changed.

We also present evidence on the disclosure strategies of firms with PEA revisions. For 46% of the PEA revisions, there are no disclosures about accounting issues prior to filing the 10-K report. In 19% of the cases, firms foreshadow the impending PEA revision in the preliminary earnings releases, with the remaining firms disclosing the PEA revision through a Form 8-K issued prior to the 10-K filing.

Finally, we provide additional evidence on the economic significance of the PEA revisions by examining the market reaction to their disclosure. Consistent with prior evidence of a negative market reaction to announcements that previously-filed earnings numbers will be restated (e.g., Palmrose et al., 2004; Anderson and Yohn, 2002), we find

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